To state the obvious, everything on a form that you file with the IRS should be factually accurate. Above and beyond the fact that a 501(c)(3) organization must sign Form 990 (including Schedule K) under penalty of perjury, even innocent mistakes can needlessly raise the risk of an IRS audit. We know that the IRS Tax-Exempt Bond Division coordinates with the Exempt Organizations Division and reviews the information on Schedule K to select bond issues for audit and to develop broader audit programs. So it is particularly important to get this information right, especially where there are no substantive problems with a bond issue, but incorrect reporting makes it appear to the IRS that there are.
We see 501(c)(3) conduit borrowers make some of the same mistakes over and over on Schedule K. Some of them are harmless typos and foot faults. But others could potentially put the bond issue at needlessly heightened risk of an IRS audit. In this post, we’ll cover some common mistakes and pitfalls, and we’ll give you some tips for handling them.
One other point before we begin. For a variety of reasons, it is not common practice for 501(c)(3)’s to have bond counsel (as opposed to their own counsel) review the Schedule K before it is filed. It’s a good idea to have bond counsel review it, particularly if you have any doubts at all about how anything should be reported.
Before we start, you may want to print out Schedule K (pdf), and the Instructions to Schedule K (pdf).
Part I – Column (h)
If you didn’t issue your own bonds, you’re not an “on behalf of issuer.” Part 1, column (h) asks you to check whether or not the bonds were issued by an “on behalf of issuer.” For the vast majority of 501(c)(3)’s, the “No” box should be checked. Although in a colloquial sense the typical conduit issuer is issuing the bonds to borrow funds from the public on the 501(c)(3)’s behalf, this is not what Schedule K is getting at here. This question is referring to a very narrow class of 501(c)(3)’s that have such a close connection to a State or local governmental unit that the 501(c)(3) itself is treated as an extension of that governmental unit and can exercise the State or local government’s borrowing power and issue its own bonds “on behalf of” that State or local governmental unit. (See Rev. Proc. 82-26 and Rev. Rul. 63-20 for more detail.) Again, the vast majority of typical 501(c)(3)’s should check “No” here.
Part II – Some General Thoughts
To complete Part II, you should gather:
- The tax compliance/non-arbitrage certificate for the issue (a closing memo or flow of funds doesn’t necessarily work because the proceeds may have been allocated in a way that differs from the flow of funds)
- The 8038 for the issue
- If you’ve done an allocation that differs from the actual flow of funds at closing, any materials that show the items to which proceeds were allocated and the amounts of proceeds that were allocated
- Items showing the amount of investment earnings on bond proceeds (account statements or summaries)
- A good analgesic
- A portion – nay, all – of your courage and cunning
Part II is where we see the most mistakes. If it helps, you can think of Part II as consisting of three sub-parts. Questions 1 and 2 are about accounting for the status of the bonds. Questions 3-12 are about accounting for the amount and uses of bond proceeds. Questions 13-17 then ask some general questions about the use of bond proceeds.
Now, some specific comments:
Part II – Lines 1 and 2
Line 1 refers to the cumulative amount of bonds that have been paid off – either actually refunded or paid off at maturity. So, if you reported $1,000,000 of bonds retired in 2012, the amount you report in every year thereafter should be at least $1,000,000.
The best example of an item that would go in Line 2 is if in 2013 advance refunding bonds are issued to advance refund the bonds that are being reported on Schedule K, the advance refunding escrow is funded to defease the advance refunded bonds, but the advance refunded bonds haven’t yet reached their call date. You would enter the amount of bonds that have been defeased, but not yet paid off, by that later advance refunding escrow in Line 2. Later, in the tax year when you reach the call date for the bonds, and actually pay them off, you’ll move those amounts from Line 2 to Line 1.
Part II – Line 3
Now we’re into the second sub-part of Part II. Think of this subpart as similar to a “Sources and Uses” table for a bond issue.
The amount you put in Line 3 will equal the sale proceeds of the issue, plus any investment proceeds earned on the investment of those sale proceeds – even if they’re exempt from rebate.
The instructions have a confusing phrase here – they say to report the total amount of bond proceeds “as of the end of the 12-month period.” That might lead you to believe that as proceeds are spent, the number in this line should decrease. The better view is that Line 3 should contain the cumulative total of all sale and investment proceeds. Don’t subtract proceeds from this Line as you spend them.
Also note – if you have any investment earnings, you’ll need to drop the IRS a note in Part VI to tell them why the total proceeds shown here exceeds the issue price in Part I, Column (e).
Part II – Line 4
Here’s a potential landmine. Contact counsel if the amount that you think is the correct amount exceeds 10% of the lesser of the par amount or the issue price shown in Part I, Column (e). There’s a flat prohibition (“the third rail,” as Mike is fond of saying) against having sale proceeds in a reserve fund in an amount that is more than 10% of the par amount (or sale proceeds if there’s more than de minimis discount or premium – see Reg. 1.148-2(f)(1)). If you’re close, have someone double-check this.
It would be very easy to program a computer to compare the par amount and issue price with the amount shown here, and take some action where the amount shown is greater than 10%, and there’s no reason to invite scrutiny when you’ve gone to the trouble of complying with the limitations.
Part II – Line 5
You should fill in the amount of sale proceeds and investment proceeds that were used to pay capitalized interest. This generally means interest accruing on bonds before the bond-financed project is placed in service.
For qualified 501(c)(3) bonds, we often don’t draw a sharp distinction between capitalized interest and interest that is treated as a working capital expenditure for tax purposes. This is because the arbitrage rules give us an exception from the beehive that is the proceeds-spent-last rule for any funded interest on a qualified 501(c)(3) bond within three years of the issuance date (and sometimes beyond). So, there’s no reason to draw a distinction (except for purposes of the $150 million non-hospital bond limitation, sometimes) between interest that would be treated as a capital expenditure and funded interest that would be treated as working capital but that qualifies for the exception from the proceeds-spent-last rule – they’re treated the same for arbitrage purposes.
But Schedule K asks you to draw that distinction. If you use sale proceeds or investment proceeds to pay interest on the bond issue of which they are proceeds, you should only report the amount of proceeds used to pay capitalized interest on Line 5.
Part II – Line 6
If the bonds were advance refunding bonds (or a current refunding that just happened to close within 90 days of the end of your tax year), and you still have proceeds in an escrow, you’ll have something to fill in here. Make sure that you cross-reference Part II, Lines 14 and 15. Also, if the proceeds were at one time in an escrow, but were used to pay off the prior bonds before the beginning of the current tax year, don’t list those amounts here. (See Line 11, below.)
Part II – Line 7
Ok – let’s make a pact. Let’s all agree that we will never let a draft of a Schedule K leave our desk if the amount in this line exceeds 2% of the sale proceeds of the issue. Ok? Great.
This is the single biggest mistake we see. Worse, it’s one of the easiest potential issues for the IRS to detect (again, just program a computer to alert you whenever this exceeds 2% of the amount filled in as the sale proceeds). And it’s almost never a substantive problem – it almost always results from incorrectly including something (such as a letter of credit fee) in the total, when it doesn’t belong there. Just because something is, colloquially, a “cost of issuance” does not make it an “issuance cost” subject to the 2% limit.
Part II – Line 9
Check with your counsel if the amount that you think should be filled in here exceeds 5% of the net proceeds of the issue. This is the line that you should use to report any funded interest that isn’t treated as a capital expenditure for tax purposes (see the note for Part II, Line 5, above).
Part II – Lines 10 and 11
Where should you fill in the amount of proceeds of the issue that you’ve used for a current or advance refunding of prior debt?
Good question. Some counsel used to include those amounts in Line 10. The instructions now make clear that this isn’t the proper approach. Because for some reason there’s no clear place to list this very common use of bond proceeds, it should be included in Line 11 (“Other spent proceeds”).
Part II – Summary and Advil Break
In summary, make sure that you don’t let a Schedule K leave your desk without making sure that everything in Part II is accurate and especially that:
- The amount of sale proceeds reported as being in the reserve fund in Part II, Line 4 doesn’t exceed 10% of par or sale proceeds (whichever applies)
- The amount of issuance costs shown as being financed in Part II, Line 7 doesn’t exceed 2% of sale proceeds
- The amount of working capital shown as financed in Part II, Line 9 doesn’t exceed 5% of the net proceeds
Obviously, you want to be sure that none of these potential red flags are linked to real, substantive problems. But most of the time, they’re just incorrect reporting of the facts, and you definitely don’t want to give the appearance of smoke if there’s no fire.
If any of these apply, check with your counsel before moving on.
Part III – Lines 3a – 3d
For Line 3a, if there are any management contracts pertaining to the bond-financed facilities, you should check yes. Even if you’ve concluded that the management contract fits within a Rev. Proc. 97-13 safe harbor from private business use, you should still check yes. Same thing with Line 3c – if you have research contracts, even safe-harbor research contracts, you should check yes.
For Lines 3b and 3d, if you say that you consult with counsel, just make sure that you do. That’s good practice not just for Schedule K reporting purposes, but generally.
Part III – Lines 4 and 5
Even though proceeds used for issuance costs count as private business use, don’t factor them in when you calculate this percentage.
Because this is asking you for a measurement of annual private business use, and the private business use test focuses on the average annual private business use over the measurement period, it’s possible that this percentage could exceed 5% in a given year. If it does, it’s a good idea to drop a note in Part VI.
(We will leave you to speculate about why the instructions tell you to report private business use to one decimal place using an example – 8.9% (!) – that exceeds the private business use limit on a snapshot basis.)
Part III – Line 7
Meeting the private security or payment test is like meeting Clubber Lang in the ring – you don’t want to do it, and you probably didn’t even mean to say that you’d do it. If an issue “meets” both the private business use test and the private security or payment test, then the bonds are (probably unintentionally taxable) private activity bonds. If the bonds have private payment or security that is within permitted limits, or more likely none at all, check “No.”
Part IV – Lines 2a-2c
You can tie yourself in a knot over this one. Keep in mind that the instructions say to check any of the options that apply. Line 2a should be checked if you haven’t reached the first rebate due date yet. For most issues, you’ll check yes if the bond issue isn’t more than 5 years and 60 days old on the end of the tax year to which the Schedule K relates. If the bond issue was a pure current refunding that qualified for the 6-month spending exception to rebate, and the first rebate computation date hasn’t arrived yet, you’d check “Yes” in both box 2a and 2b.
Those are the most common mistakes we see that are the most likely to raise red flags with the IRS. Do you have other common mistakes that you see? Let us know in the comments.